Questions for Review with Answers
Chapter 9. Demand Theory II. Elasticity. Indifference Analysis
I. Basics
Chapter 9 – Question 1
Define elasticity.
* It is a more than proportionate change in quantity demanded to changes in other variables.
Chapter 9 – Question 2
Do you remember the rule of thumb?
* Elasticity is always measured with the help of a fraction. In its numerator is always "Percentage change in quantity demanded". Demand is price elastic or income elastic when the numerator exceeds the denominator. Demand is cross elastic when the numerator is equal to or exceeds the denominator.
II. Price Elasticity
Chapter 9 – Question 3
If the demand curve is a linear line, where is demand unit elastic, elastic and inelastic?
* Demand is unit elastic at the midpoint, elastic above it and inelastic below it.
Chapter 9 – Question 4
How do you calculate elasticity between two points?
* With the help of the endpoint method. The formula is: Change in quantity/Average quantity : Change in price/Average price.
Chapter 9 – Question 5
Explain why unit elasticity and inelasticity do not contradict the law of demand.
* In either case, the changes in quantity demanded that the law of demand predicts have taken place.
Chapter 9 – Question 6
Describe the implications of price elasticity and price inelasticity for business revenues.
* If demand is price elastic, a price rise will lower business receipts, a cut will increase them.
If demand is price inelastic, a price rise will raise business receipts, a cut will lower them.
Chapter 9 – Question 7
Describe the relationship between the slope of the demand curve and price elasticity.
* On the one hand, one can say that the steeper the slope is, the lower is elasticity. On the other hand, one must see that slope and elasticity are not identical; they are calculated by different formulas.
Chapter 9 – Question 8
Give a numerical example (%Δ in quantity demanded : %Δ in price) of each of the following:
A. zero elasticity
B. inelasticity
C. unit elasticity
D. elasticity
* A. zero elasticity 0/10
* B. inelasticity 5/10
* C. unit elasticity 10/10
* D. elasticity 10/5
Chapter 9 – Question 9
The quantity demanded for Commodity A rises by 12 percent. The price elasticity of demand is 1.3. By how many percent must the price of Commodity A therefore have fallen?
* By 9.23 percent. To get the answer divide 12 by 1.3
Chapter 9 – Question 10
Your university raises tuition fees to raise its revenues. What does it think about price elasticity of tuition?
* It thinks it is inelastic. The university believes that the number of its students will not fall significantly in response to the rise in tuition fees. Unit elasticity would mean that revenues remain the same.
Chapter 9 – Question 11
The price of a commodity drops from $5 to $4.50. Quantity demanded rises from 500 units to 525 units. What is price elasticity?
* 05. (5 percent/10 percent.)
III. Cross Elasticity
Chapter 9 – Question 12
Compare the value of the fraction measuring cross elasticity for complements with the value of the fraction measuring cross elasticity for substitutes.
* Complements have fractions with negative value, because quantity demanded of A rises when price of B falls. Substitutes have fractions with positive value, because quantity demanded of A rises when the price of B rises.
IV. Income Elasticity
Chapter 9 – Question 13
Explain why the income elasticity of inferior goods is negative.
* For demand to be income elastic, the percentage increase in quantity demanded must exceed the percentage increase in income. This is unlikely to happen with inferior goods. When incomes rise, people buy less of the inferior good because they substitute superior goods for the inferior good. When incomes fall, they buy more of it because they substitute the inferior good for superior goods, which they bought when their incomes were higher.
V. Some Examples
Chapter 9 – Question 14
Name the characteristics of goods for which price and income elasticity are likely to be high.
* Goods that have substitutes, goods that are narrowly defined, goods that are luxuries. A long time horizon increases elasticity.
VI. Advanced Topic: Indifference Analysis
Chapter 9 – Question 15
What is the aim of indifference analysis and how is it achieved?
* The aim of indifference analysis is twofold: explain consumer decisions for bundles and circumvent the problem that utility cannot be quantified. It is achieved by assuming that consumers define prices in terms of barter prices. They buy a bundle when two conditions are fulfilled: The ratio between their barter prices equals the ratio between actual market prices, and, secondly, the bundle is affordable for them.
Chapter 9 – Question 16
Write down the equation to express optimal consumer choices that is used in indifference analysis.
* Amount of commodity scarified/Amount of commodity gained = Price of commodity gained/Price of commodity sacrificed
Chapter 9 – Question 17
And the formula to calculate the MRS.
* Change on y-axis/Change on x-axis
Chapter 9 – Question 18
Explain why the slope of indifference curves equals the MRS.
* They are calculated by the same formula: Change on y-axis/Change on x-axis
Chapter 9 – Question 19
Why can two indifference curves not intersect?
* An intersection would violate the more-is-better principle. An intersection means that a consumer moves from a higher indifference curve to a lower one or vice versa. The lower one has a lower overall number of goods in every bundle.
Chapter 9 – Question 20
Your utility function for commodities x and y is u(x,y) = 2x + 6y. You buy 12 units of x and 8 units of y. You now lower your purchases of x to 6. How many units of y must you buy to get the same utility level?
* 10 units, 2 more than before. Before you made the change, your total utility was 72 (24+48).
After the change it dropped by 12. You therefore must buy two additional units of y to restore your previous utility level.
Chapter 9 – Question 21
Explain how to derive the demand curve from indifference analysis.
* Choose one of the two goods in the bundle. The tangency point where the budget line touches the highest attainable indifference curve gives you one point on your demand curve; you have a price and a quantity. Now lower the price of the good that you have chosen. This gives you a new budget line and a new tangency point and hence a second point on the demand curve.
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